What is Mean Reversion?

What is Mean Reversion?

In finance, mean reversion is a theory that suggests that asset price volatility and historical returns subsequently return to the long-run mean or average of the entire dataset. This movement in asset prices may depend on the economy, industry, or average return with a dataset. The mean level can occur in several contexts, such as a stock's P/E ratio or an industry's average return.

It also suggests that the higher the deviation from the mean is, the higher the chances of the next price movement being closer to the mean will be. Therefore, the theory proposes that in extreme events of increase in a stock’s momentum, the stock will subsequently experience a less extreme event that would result in lower fluctuation.

How does Mean Reversion work?

With mean reversion, investors retrace any condition back to a previous state. In the case of a mean reversion, the theory implies that any price fluctuations far from the long-term norm will again return to the understood state. This theory can influence investors' strategies that invest in stocks that have experienced recent performances that differ substantially from their historical averages.

With this strategy, investors can buy or sell stocks that have gone through an abnormal event, hoping that they will return to normal. However, some other factors may also play a role in unexpected events occurring. Therefore, investors need to consider every factor before basing their investing strategy on mean reversion.

The mean reversion theory is also prevalent in the statistical analysis of market conditions. It depends on the idea of buying low and selling high and hoping to identify any anomalies in stocks. This analysis aims to look for stocks that investors expect to return to their historical averages. Mean reversion can also be beneficial in options pricing to describe the observation that an asset’s volatility will fluctuate around some long-term average.

Lastly, the mean reversion theory also suggests that a mean point for stock prices exists. Therefore, investors can measure it and use it to make profits. For example, when a stock's price decreases from the mean, they can buy it. According to the theory, the prices will revert, which will result in a capital gain for the investor. Similarly, it suggests that when the price goes above the mean, investors should sell their stocks.

What are the limitations of Mean Reversion?

The mean reversion theory has various limitations. Firstly, it goes against market efficiency theory. This theory believes that markets reflect all available information and investors cannot outperform the market. Therefore, the mean reversion theory suggesting that investors can buy stocks at low prices and sell them does not work.

Similarly, the theory suggests that stocks experiencing price changes due to anomalies can revert to their mean position. However, there is no guarantee that it will happen. It is because any unexpected fluctuations may indicate a norm shift. Sometimes, these anomalies have a lasting effect and, therefore, the stock price may never revert to the mean.

Conclusion

The mean reversion theory suggests that asset price volatility and historical returns eventually return to the long-term mean. This theory is crucial in various investing strategies. Based on this theory, investors can customize their investment strategies to profit from market anomalies. However, it also has some limitations.

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